Can you profit from a falling
US$ by buying resource shares on non-US exchanges?

There's a widely held opinion
that you can take advantage of a weakening US$ by buying your
resource shares outside the US; in Canada, for instance. We'll
put aside, for a moment, our view that the US$ is more likely
to rise than to fall over the coming 6-12 months and look at
why this widely held opinion is logically flawed.

First, let's consider the example
of Newmont Mining, a stock that trades on several exchanges including
the New York (NYSE) and Toronto (TSX) exchanges. Regardless of
what happens to the CAD/USD exchange rate, a US investor who
buys Newmont in Canada will not do any better or worse than one
who buys it in the US because the price of the stock on each
market will adjust to account for changes in the CAD/USD rate.
For example, if the price of Newmont rises by 10% in Canada and
the CAD rises by 10% against the USD then a US investor who buys
the stock on the TSX will make 20% (10% from the price rise plus
10% from the exchange rate), but during the same period the price
of NEM in the US will rise by 20% so someone who buys the stock
on the NYSE will make exactly the same amount of profit. In fact,
the US investor who bought the stock in the US would end up doing
slightly better because he/she would avoid the currency conversion
costs (the currency conversion will typically cost you about
1% on the buy and another 1% on the sell).

The inability to gain (or lose)
from exchange rate changes in the example described above is
illustrated on the following chart. The chart compares Newmont
Mining's performance in the US, adjusted for changes in the CAD/USD
rate, with its performance in Canada. There are actually two
lines on the chart, but it looks like there is just one line
because both lines are in exactly the same place.

Many of our readers will consider
the above to be a statement of the obvious, but it's amazing
how many people think their results can be improved by buying
a stock in terms of a currency that happens to be appreciating
rather than buying the same stock in terms of a weak currency.

But what about a resource stock
that only trades in Canada? Could a US-based investor profit
from an increase in the CAD/USD rate by buying such a stock?

The answer is: it's not appropriate
to generalise. If a strong currency provided an automatic benefit
to equity investors then the shares of South African gold miners
would have been the best gold stocks to own during 2003-2004
because the Rand was the strongest currency in the world during
this period. However, they were actually the WORST stocks to
own, largely BECAUSE the Rand was so strong.

The reason the SA gold stocks
performed so poorly during the aforementioned period is that
these companies' costs were denominated in a strong currency
whereas their revenues were denominated in a weak currency (gold
trades internationally in US dollars). Because the SA Rand was
appreciating at a faster rate than gold, the profit margins of
SA-based gold producers FELL and the resultant fall in their
stock prices was much greater than any benefit a US investor
in these stocks would have received due to the gain in the Rand/US$
exchange rate.

The key to profiting from exchange
rate moves when investing in resource stocks isn't to buy the
stocks whose prices are denominated in a strong currency, but,
instead, to buy the stocks of mining companies whose COSTS are
denominated in a WEAK currency. A company that sells gold in
US dollars and incurs most of its costs in terms of a currency
that is weakening relative to the US$ will get a dual boost to
its profit margins in a rising metal price environment.

There are many mining companies
that incur most of their costs outside Canada even though they
have their corporate headquarters in Canada and trade on the
TSX/TSXV. The stocks of these companies have the potential to
do particularly well in the face of a rising CAD, but the bottom
line is that a stock's performance over the long-term will be
determined by its actual and/or projected profits and not by
the performance of the currency in which its shares happen to
change hands. In the short-term almost anything can happen and
when traders feel very optimistic about natural resources it's
likely that most resource-oriented shares will surge, even the
ones that could eventually be hampered by having their costs
denominated in terms of a strong currency.

On a related matter it's important
to understand that when you buy a stock the currency you are
exposed to isn't necessarily the currency that you happened to
use to make your purchase. Rather, the assets of the underlying
company will determine your currency exposure. For example, iShares
Japan (EWJ) trades in US dollars on the American Stock Exchange,
but someone who buys this stock ends up with a long position
in the Japanese Yen, not the US$, because EWJ's assets are Yen-denominated.
If, for instance, the prices of EWJ's assets were to remain the
same while the Yen gained 10% against the US$ then the price
of EWJ would rise by 10%. By the same token, when you buy gold
bullion the currency you use to make the purchase is irrelevant
because what you end up with, in all cases, is ounces of gold.